Economics of Virtual Worlds

Wednesday, April 1, 2009

I have just updated an old post, Virtual Worlds & Pop Culture, and wanted to make a note that this is a list that I will be trying to keep active. So if you see any TV shows or movies in which virtual worlds or game worlds comprise a significant portion of the plot, please drop me an email.

Thursday, March 26, 2009

Just a quick follow up on my September 2008 post Blizzard L00t, which discussed the profitability of World of Warcraft. In that post, I arrived at an extremely rough estimate of $80 million a month in revenue from WoW. Although I didn't get directly into annual WoW profit figures, a Wall Street Journal article provides some perspectives from the financial markets:

Blizzard generated $704 million in profits on revenues of $1.3 billion in 2008, according to regulatory filings. Analysts believe most of those results are tied to WOW. (emphasis added)

If the "analysts" are right (I wonder how many of them have even played WoW?), then my initial dollar estimates were a bit low, but not terribly inaccurate, while WoW's relative share of revenues/profits was likely more accurate.

Tuesday, March 10, 2009

Sadly, I received an email this week notifying me that Nick Yee’s The Daedalus Project website is going into “hibernation mode,” which unfortunately sounds to me a lot like a permanent end to this much-valued resource. The website and its research will remain up, but the man behind the magic, Nick Yee, has completed his PhD and has other challenges to undertake. In his farewell, he says "I’m still deeply interested and fascinated by the MMO space, but I think I came to realize that continuing the project would require more time than I could devote to it."

The Daedalus Project has for years been a unique source of survey information about virtual worlds and their players. Data on favorite character classes, gender bending, motivations, demographics and a host of other variables has been freely put on display here. The MMO world is suffering a significant loss with the “hibernation” of The Daedalus Project. I trust that Nick’s future endeavors will yield equally fruitful research (even if it isn’t in the field of MMOs). Although he doesn’t say what changes are in store for him personally, hopefully Yee will continue his work in online games and immersive virtual reality as a research scientist at the Palo Alto Research Center’s (PARC) PlayOn group.

For all that he has done in the last 9 years, I say “thank you.” For all that he plans to do going forward, I wish him the best of luck.

Thursday, February 5, 2009

I went this week to a demonstration/ exhibition put on for Members of Congress and their staffs by the U.S. Army's PEO STRI office. The purpose of the event was to give us "the chance to experience interactive military simulations and training devices that currently prepare Warfighters for their missions." I came away impressed by what our military is already doing with virtualization and the potential for virtual worlds.

One demonstration that impressed me used a 3-D camera and Second Life (plus 3 large LCD panels). The 3-D camera translates the movement of a human being into movement by an avatar. In the demonstration I saw, there was a virtual punching bag that existed solely in Second Life. When the user throws a punch in the real world, the system reacts by showing the virtual punching bag being hit. Users can also move their avatars around Second Life simply by leaning forward. Very cool! Update: As Tami notes in her comment to this post, the punching bag is not actually in Second Life. It must therefore, I think, be in a construct created with the SL code, but not on the SL grid (kinda like the sparring program in The Matrix?).

I learned from talking with folks at the exhibition that the Army has begun using Second Life to a significant degree. While Forterra's Olive software is being used in parts of the military, Second Life has the appeal of being open source, so end users (such as PEO STRI) can easily develop their own scenarios.

Another impressive demonstration was Virtual Battlespace 2 (VBS2). VBS2 allows soldiers and their commanders to conduct virtual training in environments designed by the soldiers themselves. Thus, a platoon could map out a detailed, realistic simulation of an upcoming mission. They could then use it to identify potential choke points along the route, learn to identify key markers in the dark, and scope out enemy sniper positions. VBS2 further offers the capability for some soldiers to play as the enemy (or civilians), such as a sniper or roadside bomber, thus adding an element of surprise, intelligent response, and immersiveness. VBS2 could also be used to help train a National Guard unit that is about to deploy to Iraq or Afghanistan. A unit in the field could play the role of the opposing force, and the new unit could practice how to identify IEDs and locally-unique aspects of their deployment.

One of the best features is that soldiers and officers can design and modify VBS2 scenarios, which then go into a communal library of sorts. One field commander might design a sim to train his soldiers on convoy protection near Kohat. Another commander could then use that same scenario to develop a sim for interacting with local tribesmen, or he might tweak the sim for a night-time raid when there's 3 feet of snow on the ground.

VBS2 is clearly an exciting technology, and is already being used by the Army. A basic VBS2 deployment consists of around 50 networked computers, corresponding to the size of 1 platoon. Additional groups can be assembled allowing for upwards of 250 soldiers. Fort Lewis, KY is the primary deployment site for VBS2 thus far, where it has been well-received.

Talking with some of the members of the Army, it was clear to me that the adoption of such virtualization technologies complements nicely the fact many soldiers grew up playing, and continue to play, warfighting games. Many of these soldiers are already familiar with Call of Duty and other games, so they take to these virtual trainers quite enthusiastically.

From an economics perspective, the benefits are clearly the cost-efficiency of virtual training. Giving a trainee an extra hour on a simulated construction vehicle costs far less than going through all the regulations required to identity land for digging, wear and tear on the machine, and damage to an environment (not to mention the added bonus of letting them train in a variety of settings -- jungle, mountains, etc. -- for no additional cost). VBS2 allows for soldiers in the field to transfer hands-on street knowledge to incoming units, and the ability to work through mission simulations will hopefully cut down on casualties. All these benefits, and yet the marginal cost for an additional hour on the virtual trainer/sim is next to nothing. Although development and deployment costs can be significant, it seems abundantly clear that in the long (and even in the short) run, the benefits of virtualization far outweigh the costs.

Hagel and Brown argue that conventional training programs run by corporations suffer from an inherent limitation in that they focus on transferring knowledge rather than teaching trainees to think. They recommend that businesses consider adopting games, specifically World of Warcraft (WoW). The main benefit of WoW is that advancement is contingent on innovative problem solving:

The degree of complexity and challenge increases dramatically as you advance across levels, and the number of experience points needed in order to advance also increases sharply with each level. Yet the number of hours required to get there actually decreases. Experienced players become adept at leveraging the resources available in and around WoW to learn faster and advance faster even as the challenges become more difficult. In contrast to the diminishing returns to learning that we often encounter in business, players in WoW appear to have joined an environment where there are increasing returns to learning.

An additional benefit to WoW is the engaging (and addictive) gameplay. Once a players starts into WoW, the game becomes a self-motivating experience, in which players want to achieve that next level of achievement. Sooner or latter, this desire to play encourages players to collaborate with others in the game.

Talk about incentives in a business context, and the discussion quickly falls back to cash. With minor exceptions, cash is not an incentive to play WoW, so the designers focused on intrinsic motivations. Players get widespread recognition as they master new skills and successfully address each new challenge. As the game advances, players learn to collaborate and participate in "guilds"—teams of players who must work together to innovate in their game play and achieve the next level of performance. As relationships and trust develop within these teams, everyone is motivated to innovate by the desire not to let the team down.

The benefits to businesses go beyond imparting an ability to think innovatively or encouraging collaboration, but shaping minds to deal with new and unexpected events. This seems a particularly beneficial trait to have in a fast-moving, competitive business environment.

Rather than viewing the unanticipated as a threat, gamers learn to welcome unexpected events as an opportunity to innovate, tinker, experiment, and, in the process, learn even more. They also learn to welcome collaboration as an opportunity to learn faster by focusing on a set of individual strengths while being exposed to the diverse perspectives and experiences of those with complementary strengths. At the end of the day, this is the most powerful contribution of WoW. This disposition creates an amplifying effect throughout the game. Players seek out other players who share this point of view, and they end up performing better than players who bring more conventional ideas to the game.

Monday, January 12, 2009

The IRS office of the National Taxpayer Advocate released on 1/7/09 its 2008 Annual Report to Congress. The report identifies tax issues related to virtual worlds as a "Most Serious Problem" and features a 13-page section entitled "The IRS Should Proactively Address Emerging Issues Such as Those Arising from 'Virtual Worlds'"(starting on page 214 of volume 1). The chief concern for the IRS is summarized as follows:

Economic activities associated with virtual worlds may present an emerging area of noncompliance, in part, because the IRS has not issued guidance about whether and how taxpayers should report such activities.

More specifically:

If the tax experts at the IRS cannot figure out what the rules are or should be, unsophisticated taxpayers who participate in the virtual economy have little hope of doing so. The IRS could at least make an administrative pronouncement about how taxpayers should treat these transactions in the interim as it studies the issue and the state law rules evolve. So when counting income for tax purposes, should virtual currency be discounted to reflect that risk?

The report notes the significant economic value of many items and avatars in virtual worlds, even observing that some of the limitations set forth in TOS and EULA contracts "may not be enforceable under state law." The problem, according to the National Taxpayer Advocate, ultimately boils down to economic activity:

The economic activity in virtual worlds is significant.…In other words, by participating in these worlds, a significant number of people are creating real economic income. Where there is economic income, there is likely to be tax due from someone.

The report states that one of the biggest obstacles to introducing taxes to virtual worlds is the issue of valuation:

While valuing in-world transactions conducted in virtual currency would be burdensome, especially in light of the small dollar amounts typically involved, valuing in-world trades of other types of virtual property might be nearly impossible. For example, how would we value a trade of virtual armor for a virtual sword or the income from picking up a virtual sword?

The report also raises a sticky issue that has intrigued me for a while now, and that is the ability of virtual world operators to arbitrarily terminate an account and confiscate its holdings. Although people often talk about their accounts in World of Warcraft or Entropia like they were regular financial possessions, in the real world banks can’t simply decide to confiscate your checking and savings accounts. In the realm of taxation, it would seem to me that this risk permeates all virtual world accounts and diminishes the value of any obtained assets. In certain real world situations, such as divorce proceedings, civil litigation and the federal estate tax, it is common to apply discounts to the market value of assets when another party has ultimate control over that asset or there is a lack of marketability. While not intended to cover virtual assets, there are obvious similarities. The National Taxpayer Advocate’s report picks up on this issue:

Some virtual property is not transferable under the TOS. Moreover, all virtual property is arguably subject to forfeiture at the discretion of the virtual world operator. The virtual world operator could cancel the taxpayer’s account, shut down the virtual world, or change the world in a way that eliminates the value of the virtual item. Thus, a taxpayer may wonder if such contingencies make the in-world acquisition and sale or exchange of virtual property nontaxable.

I think one of the most remarkable aspects of the NTA’s report is what it does not embrace: the much-discussed distinction between game worlds like World of Warcraft and non-game worlds like Second Life. The NTA report goes into some detail describing structured and unstructured worlds, specifically referencing World of Warcraft and Second Life. However, the report’s analysis and recommendations appear devoid of any reference to the type of world. Gold and armor in World of Warcraft is just as much a taxable item as selling virtual homes and t-shirts are in Second Life. Personally, I do not find the lack of distinction surprising, because it’s always seemed silly to me to try to categorize economic value based on intent or some contrived definition of a “game world” (I previously blogged on this here). Economic value is what it is, and whether you got through selling virtual armor or virtual homes is irrelevant. However, this distinction seems to be awfully important to some observers and researchers addressing issues of virtual worlds and taxation (for instance, see here and here). While certainly not final, I suspect the mindset embraced by the NTA regarding this aspect of virtual worlds will carry over to other divisions of the IRS as well.

Wednesday, October 1, 2008

No, I am not talking about lawyers who are disinclined to sue at the drop the hat (my apologies to all my lawyer friends out there). What I am talking about is a lawyer who understands economics. We all specialize in our field of expertise, and it’s refreshing to see a specialist in one field demonstrate insight in another.

First, in talking about the contest between subscription based models (a la World of Warcraft), they distill the core argument for why RMT makes economic sense over the subscription model. As explained by Eisert and Boyd, RMT allows for the greatest extraction of value from an MMO by allowing customized levels of commerce.

"… traditional subscription models and even advertising are relatively blunt instruments for monetizing online worlds. Both of these methods tend to assign the same value to every customer. A subscription charges a customer a monthly or annual cost and advertising pays per user or per view at a set cost. But, people do not value goods this way. Each person places a different value or ‘willingness to pay’ to be a part of an online community. RMT helps companies extract that value." (emphasis added)

They describe the benefits of RMT if properly implemented:

"… RMT allows game companies to satisfy that need and extract appropriate value as well by ‘fine tuning’ the price point so that each user pays the price the service is worth to him individually."

To illustrate this point, I’ve prepared a couple of graphs. In both, the curved line represents the willingness-to-pay of the users. All the line says is that some people are willing to pay more for a game, while others will only pay less. The first figure depicts a hypothetical flat-fee subscription-based virtual world. I’ve indicated areas where revenues could be higher in two places. First, there are some potential players who simply find the game too costly: the flat-fee is greater than their willingness to pay for the game. Second, there are current players who are in fact willing to pay more for the game than they actually are, but since the game has a flat fee structure, there is no way to capture that untapped willingness-to-pay.

The second figure shows a hypothetical game based on RMT. In it, each player decides how much money he or she wants to spend in the game. Players who only want to pay the minimum can do so, while others can pay up to the maximum amount they are willing to spend. The result is that players end up paying much closer to their individual willingness-to-pay amount. It may not be a perfect match, but it comes much closer to the willingness-to-pay-curve than the flat-fee world. The revenue for each game is represented by the area of the red- or blue-shaded rectangles. If you were to actually do the math, you’d find that (in this hypothetical example) the blue-shaded area was larger than the red-shaded area.

Before I conclude, there’s one last point to mention about the Eisert and Boyd article. Toward the end of the article, they make a rather curious, albeit 100% accurate observation about virtual currencies.

"… most anyone would rather have World of Warcraft gold, supported by its 10 million player subscriber base, than the Zimbabwe dollar, which is currently in the midst of a hyper-inflation crisis."

Notwithstanding its virtual nature and the difficulties in converting it to U.S. dollars, virtual gold (or other virtual currency) would still be preferred over real world currencies that suffer from hyperinflation.

** As requested, I've edited the figures to add labels. For additional discussion on the issues raised here, see Matt Mihaly's post at The Forge, and Raph Koster's post at his blog. **